The Bankruptcy Code provides tax relief when debtors sell property "under a plan confirmed" in a Chapter 11 case. Debtors, those acquiring properties from debtors in a Chapter 11 case, and lenders have taken advantage of this tax exemption to avoid payment of state and local transfer and mortgage recording taxes. Such taxes can be significant for properties in locations such as New York City, where state and local transfer taxes may exceed 3% of the consideration paid for the property. This tax exemption has motivated lenders to take back collateral from defaulting borrowers through a confirmed bankruptcy plan rather than a foreclosure sale. It used to be common for bankruptcy courts to sign orders declaring property sales by debtors to be free and clear of transfer and mortgage recording taxes even where the debtors had not yet confirmed a plan of reorganization.

But two federal appellate courts and an Illinois federal court have held that the bankruptcy tax exemption is available only if the closing of the transfer occurs after the debtor has confirmed a Chapter 11 plan of reorganization. Similarly, last year a New York federal court reversed the ruling of a bankruptcy court that allowed the exemption to be invoked with respect to a sale that closed before the debtor had filed its proposed plan of reorganization.

Thus, it is significant that a New York bankruptcy judge recently adopted a more flexible test, holding that the bankruptcy tax exemption may apply to a debtor's sale that closes before the debtor confirms a plan of reorganization, if the sale is in view of, and integral to, plan confirmation and the plan contemplating the sale is ultimately confirmed. In that case, the Debtor was able to sell 23 properties with the approval of its secured lender, and the court observed that it did not foresee any obstacles to confirmation of the plan, in view of the results of the sales process. The court chose to adopt this more flexible test after noting that a debtor may need to arrange financing or to close a sale in order to obtain its creditors' consent to proceed with plan confirmation.

Where does this leave us? It depends where the debtor's Chapter 11 case is pending. If it is in one of the states within the federal judicial circuits that adopted the bright-line pre/post plan confirmation distinction—Delaware, Pennsylvania, New Jersey, Maryland, Virginia, West Virginia, North Carolina or South Carolina--a transaction may qualify for the exemption only if it occurs after plan confirmation. For cases pending in other states, there is no bright -line test, and there is a chance the court may adopt a more flexible approach.